Fundamental Analysis
Fundamental analysis is the study of economic factors that influence foreign
exchange rates in the hope of trying to forecast future rates. In contrast, technical
analysis involves the study of volume and price levels, and chart patterns
of currencies to forecast future currency moves, which is predicated on the assumption
that certain patterns in the charts can forecast, more often than not, exchange
rates.
It is fundamental analysis, however, that ultimately determines currency rates,
since it is based on cause and effect. Hence, fundamental analysis involves analyzing
those factors that have a direct effect on foreign exchange rates. Since any forex
transaction involves the exchange of 1 currency for another, fundamental analysis
must, by necessity, take into account the supply and demand of each currency with
respect to the other, which determines the exchange rate. Hence, proponents of fundamental
analysis try to ascertain supply and demand by studying various economic indicators
and other economic data which will affect the supply and demand of each currency
with respect to the other.
The most important economic factors analyzed to forecast exchange rates, especially
with respect to the major currencies, are the country's economy, particularly
those factors that affect the inflation rate, interest rates, and the return on
investments compared to other countries.
A country that is growing rapidly will tend to draw investments from around the
world to take advantage of the growth rate. Indeed, foreign investments have generally
done much better in this decade than investments in the United States, because most
countries are much less developed and have a greater potential for growth. Foreign
investments require exchanging domestic currency for the foreign currency, and this
increases the demand for foreign currency and reduces the demand for the domestic
currency. If a Brit wanted to invest in the hot stock market in the late 90's
in the United States, for instance, he would have to convert pounds into U.S. dollars,
which reduces the demand for pounds and increases the demand for dollars.
Countries with higher interest rates tend to draw more money from the rest of the
world, when investors seek to gain a higher return by investing in the country.
One such example is the so-called carry trade, which involves borrowing currency
from a country with low interest rates to invest it in a country with higher rates.
A good current example is the Japanese yen-New Zealand dollar carry trade. Japan
has a very low interest rate of 0.50% and New Zealand presently has the highest
interest rate among developed countries—8%.
Inflation is the result of an increase in the supply of a currency, which thereby
reduces demand, but, as with the other factors, it must be compared to other currencies.
It is the rate of growth of supply of 1 currency over the rate of growth of the
supply of another that will determine the exchange rate between the 2 currencies.
Another factor that will affect supply and demand for a currency, especially for
developing countries, is the country's political stability. There will be little
demand for the currency of an unstable country, since few people will want to invest
where there is a great deal of risk, which reduces the demand for the currency,
and, therefore, its rate.
Since inflation, interest rates, and returns on investments are the most important
factors in determining exchange rates, those economic indicators, which are published
regularly in most countries, that give the greatest information about these factors
will be given the greatest weight by traders, and any surprises in the published
information that differs significantly from what the market anticipated can move
the exchange rate dramatically. Hence, the key to forecasting exchange rate moves
using fundamental analysis requires that the trader know the publication schedule
of major reports for each relevant country and understand their significance.
Economic Indicators
Economic indicators are statistics, published periodically, that measure
various factors of the economy, many of which affect, or are affected, by the supply
and demand of the domestic currency. Moreover, central banks rely on economic indicators
to formulate monetary policy, which can have a significant effect on foreign exchange
rates. Virtually every country has its own economic indicators, and in trying to
forecast the exchange rate between 2 currencies, the economic indicators of both
countries must be considered in trying forecast the direction of the movement of
the currency pair. Because the United States dollar is arguably the most important
currency, and because economic indicators for other major countries are similar,
some of the more important indicators for the United States are listed below.
Beige Book
In formulating the nation's monetary policy, the Federal Reserve considers a
number of factors, including the economic and financial indicators which follow,
as well as the anecdotal reports compiled in the
Beige Book, otherwise known as the Summary of Commentary on Current Economic
Conditions. This report is published 8 times per year. Each Federal
Reserve Bank gathers anecdotal information on current economic conditions in its
District through reports from Bank and Branch directors and interviews key business
contacts, economists, market experts, and other sources. The Beige Book summarizes
this information by District and sector. An overall summary of the 12 district reports
is prepared by a designated Federal Reserve Bank on a rotating basis.
Real Gross Domestic Product (GDP)
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Definition: The total value of goods and services produced within the borders
of the United States, regardless of who owns the assets or the nationality of the
labor used in producing that output. (In contrast, Gross National Product
(GNP) measures the output of the citizens of the US and the income from assets
owned by US entities, regardless of where located.) The growth of output is measured
in real terms, meaning increases in output due to inflation have been removed.
Source: US Department of Commerce; Bureau of Economic Analysis.
Frequency: Quarterly.
Availability: Data are typically released during the final week of the month.
The first or advance estimate is released during the final week of the month immediately
following the end of a calendar quarter.
Reason: The Federal Reserve's primary goal is sustained growth of the
economy with full employment and stable prices. Real GDP is the most comprehensive
measure of the performance of the U.S. economy. By monitoring trends in the overall
growth rate as well as the unemployment rate and the rate of inflation, policy makers
are able to assess whether the current stance of monetary policy is consistent with
that primary goal.
Consumer Price Index (CPI)
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Definition: An index designed to measure the change in price of a fixed market
basket of goods and services. The market basket of goods and services is representative
of the purchases of a typical urban consumer. The index is intended to measure pure
price change only; attempts are made to remove changes in price resulting from changes
in quality.
Source: U.S. Department of Labor; Bureau of Labor Statistics.
Frequency: Monthly.
Availability: Generally available the second week of the month immediately
following the month for which data is being released; always released after the
Producer Price Index.
Reason: The rate of change of the CPI is one of the key measures of inflation
for the U.S. economy. Acceleration or deceleration of inflation may signal that
a change in monetary policy may be appropriate.
Nonfarm Payroll Employment
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Definition: An estimate of the number of payroll jobs at all nonfarm business
establishments and government agencies. Information is also provided on the average
number of hours worked per week and average hourly and weekly earnings.
Source: U.S. Department of Labor; Bureau of Labor Statistics.
Frequency: Monthly.
Availability: Usually the first Friday of the month for the immediately preceding
month; occasionally released on the second Friday.
Reason: Growth of employment and hours worked provide important information
about the current and likely future pace of overall economic growth. Trends in average
hourly earnings provide information about supply and demand conditions in labor
markets, which may provide signals about the overall level of resource utilization
in the economy.
Housing Starts
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Definition: An estimate of the number of housing units on which construction
was started. Starting construction is defined as excavation for the footings or
foundation, or the first shovel of dirt to break ground. (In response
to natural disasters such as Hurricane Andrew in August of 1992, that definition
has been expanded to a housing unit built on an existing foundation after the previous
structure had been completely destroyed.) Housing starts are divided
into single-family and multifamily(2+) units. Beginning construction on a 100 unit
apartment building, for example, is counted as 100 starts.
Source: U.S. Department of Commerce; Bureau of the Census.
Frequency: Monthly.
Availability: Around 15th of the month for the immediately preceding
month.
Reason: Housing is perhaps the most interest-rate sensitive sector of the
economy. It often experiences large swings in activity in response to changes in
the level of long-term interest rates such as those on mortgages. While residential
investment represents just 4% of the level of GDP, due to its volatility it frequently
represents a much higher proportion of changes in GDP over relatively short periods
of time. Policy makers monitor the housing sector carefully for clues about the
near-term performance of the economy and for the effects of changes in financial
conditions.
Industrial Production/Capacity Utilization
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Definition: An index designed to measure changes in the level of output in
the industrial sector of the economy. The index is grouped by both products (consumer goods, business equipment, intermediate goods, and materials)
and industry (manufacturing, mining, and utilities).
Source: Board of Governors of the Federal Reserve System.
Frequency: Monthly.
Availability: Preliminary estimate released around the middle of the month
for the immediately preceding month.
Reason: While the industrial sector of the economy represents only about
20% of GDP, because changes in GDP are heavily concentrated in the industrial sector,
changes in this index provide useful information on the current growth of GDP. The
level of capacity utilization in the industrial sector provides information on the
overall level of resource utilization in the economy which may in turn provide information
on the likely future course of inflation. Greater utilization will tend to increase
inflation.
Retail Sales
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Definition: An estimate of the total sales of goods by all retail establishments
in the U.S. (Sales of services are not included.) Data are
presented in nominal, or current, dollars, meaning they are not adjusted for inflation.
However, the data are adjusted for seasonal, holiday, and trading-day differences
between the months of the year. Sales are categorized by type of establishment,
not by type of good.
Source: U.S. Department of Commerce, Bureau of the Census.
Frequency: Monthly.
Availability: Advance estimate released during the second week of the month
for the immediately preceding month.
Reason: Personal consumption expenditures (PCE) represent roughly
2/3 of GDP. By monitoring retail sales, policy makers are able to make an assessment
of the likely growth of PCE for the current and future quarters.
Business Sales and Inventories
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Definition: Total current-dollar sales and inventories for the manufacturing,
wholesale, and retail sectors of the economy.
Source: U.S. Department of Commerce; Bureau of the Census.
Frequency: Monthly.
Availability: About 6 weeks from the end of the month; for example, data
for June are reported in mid August.
Reason: This release is the primary source of data on inventories. The rate
of inventory accumulation plays a key role in determining the current pace of economic
growth and often provides useful clues about the future pace of growth as well.
For example, if inventories are accumulating at a rapid pace, such that inventory
sales ratios are rising, it may portend a slowing of growth in the near future as
firms cut production to bring inventories back into line with sales. Vice versa,
if inventories are growing slowly or actually falling, it may signal a future pickup
in production.
Advance Durable Goods Shipments, New Orders and Unfilled Orders
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Definition: Data on shipments, new orders, and unfilled orders, expressed
in current dollars, for things such as primary metals, fabricated metals, electric
generating equipment, nonelectrical machinery, information processing equipment,
and transportation equipment, including civilian and military aircraft and ships,
light-, medium-, and heavy-duty trucks, and automobiles.
Source: U.S. Department of Commerce; Bureau of the Census.
Frequency: Monthly.
Availability: 4th week of the month for the immediately preceding
month.
Reason: The data in this report provide information on the strength of demand,
from both domestic and foreign sources, for U.S. manufactured durable goods. Rising
orders, shipments, and unfilled orders suggest demand is strengthening, which will
likely result in increasing production and employment, while falling orders, shipments,
and unfilled orders suggest the opposite. Data in this release also provides information
on the current and likely future pace of business investment in new equipment.
Light-Weight Vehicle Sales
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Definition: Total unit sales and leases of domestic and imported new automobiles
and light-weight trucks (up to 10,000 pounds gross vehicle weight).
Includes sales and leases to both consumers and businesses.
Source: Not-seasonally-adjusted sales data: Ward's Automotive Reports
and the American Automobile Manufacturers Association. Seasonal adjustment factors:
U.S. Department of Commerce, Bureau of Economic Analysis.
Frequency: 1st, 2nd, and 3rd 10 days of
each month and monthly.
Availability: 3rd business day after the relevant selling period.
Reason: While a relatively small component of the overall economy, changes
in light-weight vehicle sector often account for a large part of quarter-to-quarter
changes in the rate of growth of GDP.
Yield on 10-year Treasury Bond
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Definition: The current market interest rate or yield on U.S. Treasury bonds
maturing 10 years in the future.
Source: Board of Governors of the Federal Reserve System.
Frequency: Daily.
Availability: Daily data available in most major newspapers; daily, weekly,
and monthly data are reported in the H.15 report which is released each Monday by
the FED.
Reason: Movements in long-term interest rates such as the 10-year Treasury
rate provide information about likely future changes in the level of activity in
the interest-sensitive sectors of the economy. For example, mortgage interest rates
often move in tandem with the 10-year Treasury rate, and changes in mortgage rates
often precede changes in the level of activity in housing markets.
S&P 500 Stock Index
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Definition: One of several indices designed to measure changes in price of
a broad array of stocks.
Source: Compiled by Standard & Poor's. Available in most major newspapers
and several on-line market information sources.
Frequency: Daily through newspapers; instantaneous through on line information
sources.
Reason: The stock market is one measure of the current value of the nation's
stock of capital and is often viewed as a barometer of business and consumer confidence
regarding the future. A high and/or rising stock market may signal robust growth
of business investment and consumer spending in the near future while a low and/or
falling stock market may signal sluggish spending. For this reason, the S&P
500 is 1 component of the Index of Leading Indicators.
M2
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Definition: One measure of the nation's supply of money, defined as M1
(currency in circulation, demand deposits, travelers' checks, and
other checkable deposits) plus non-institutional money market funds and
small time and savings deposits.
Source: Board of Governors of the Federal Reserve System.
Frequency: Weekly and monthly.
Availability: H.6 report. Weekly data released each Thursday afternoon after
4:30 p.m. Monthly data released in either the 2nd or 3rd week
of the month.
Reason: While the strength of the relationship has weakened over time, many
people believe there is a link between growth of the supply of money and growth
of nominal GDP.